If you're like many people who have saved for retirement, you probably have most, if not all, of your money in pre-tax accounts like 401(k)s, 403(b)s, or traditional IRAs. As you approach retirement, you may be wondering if you should convert any of this money to a Roth IRA.
In this article, we'll take a look at Tom and Camille's retirement plan to see if Roth conversions make sense for them, and at what pace. With Roth conversions, there's often a sweet spot—you'll see here in just a minute that there comes a point where it doesn't make much sense to convert more.
Understanding Roth Conversions
Before diving into Tom and Camille's case, let's briefly discuss what a Roth conversion is and why it might be beneficial.
A Roth conversion involves moving funds from a pre-tax retirement account (like a traditional IRA or 401(k)) into a Roth IRA. When you convert, you pay taxes on the amount converted now, but the money then grows tax-free, and qualified withdrawals in retirement are also tax-free.
Factors to Consider When Deciding on a Roth Conversion
There are several factors to consider when trying to decide whether or not a Roth conversion makes sense for you:
Current vs. Future Tax Bracket What is your tax bracket today, and what will it be when you withdraw that money? If you expect to be in a higher tax bracket in retirement, converting now could save you money in the long run.
Required Minimum Distributions (RMDs) Traditional retirement accounts like 401(k)s and IRAs have RMDs when you turn age 73 or 75 (depending on your birth year). If you have a large enough pre-tax balance that continues to grow, your RMDs can be significant, potentially pushing you into a higher tax bracket.
Impact on Social Security and Medicare High RMDs can affect how much of your Social Security income is taxable and can also lead to Medicare surcharges known as IRMAA (Income-Related Monthly Adjustment Amount).
Beyond just saving money on taxes, these are other factors that we consider when doing a Roth conversion for clients.
Tom and Camille's Situation
Tom & Camille's "Financial Blueprint"
Let's look at Tom and Camille, both age 60, who are hoping to retire at age 62. They plan to live on about $5,000 per month in income. Here's a quick snapshot of their net worth:
Camille's 401(k): $250,000
Camille's 403(b): $310,000 (current job)
Tom's Rollover IRA: $450,000 (from a previous job)
Tom's 401(k): $500,000 (current job)
Primary Residence: Paid off
Total pre-tax retirement accounts: Approximately $1.5 million
Notably, they have:
No money in Roth accounts
No money in a brokerage account
Everything is in pre-tax accounts. This is very common for people who are saving for retirement.
Assessing the Benefits of a Roth Conversion for Tom and Camille
To determine whether a Roth conversion will make sense for them over the long term, let's take a look at their tax situation to visualize where the savings would come in, if any.
Visualizing Tax Brackets and Future Income
We can use a graph that shows:
Colored Lines: Representing different tax brackets, which adjust over time due to inflation and legislative changes.
Dark Blue Filled Line: Their Adjusted Gross Income (AGI) according to their current plan.
Green Line: Their AGI with a Roth conversion, since a conversion is added to taxable income.
Note: The Tax Cuts and Jobs Act is set to expire at the end of 2025, which may cause tax brackets to change unless extended.
Finding the Sweet Spot for Roth Conversions
We start by seeing which tax bracket would make sense to "fill up" based on their income.
Filling Up the 10% Tax Bracket: Minimal benefit over their lifetime.
Filling Up Higher Tax Brackets (e.g., 22% and 25%): Significant benefits, with over $1.6 million in tax-adjusted ending wealth by age 90.
Income & long-term benefits with Roth conversions (green line) vs. No conversions (blue line)
However, beyond that, the benefit starts to dwindle. Converting too much in a given year can lead to paying a large amount of taxes out-of-pocket, reducing the overall benefit.
The Sweet Spot for Tom and Camille is the 22% tax bracket.
Implementing a Withdrawal Strategy
The next step is to determine which accounts to withdraw from for their living expenses.
Default Assumption: Pro-Rata Withdrawals
Taking some funds from Roth, some from traditional, and some from a brokerage account.
Optimized Strategy: Taxable, Tax-Deferred, and Tax-Free Sequence
Let Roth Money Grow: Since Roth accounts grow tax-free, it makes sense to let this money grow as long as possible.
Withdraw from Taxable Accounts First: Then tax-deferred accounts, and Roth accounts last.
Implementing this strategy increases the benefit over their retirement.
Avoiding Medicare Surcharges
We need to ensure that their Roth conversions won't lead to Medicare surcharges (IRMAA).
Modified Adjusted Gross Income (MAGI) thresholds determine IRMAA.
For example, if their MAGI is over $233,000, they'd start to pay surcharges.
In their case, their AGI with the conversion is about $225,000 in the first year they're eligible for Medicare, so they avoid additional Medicare costs.
Even with Roth conversions, income will be below the first IRMAA threshold
Visualizing Cash Flows
For those who prefer numbers in black and white, we can look at their cash flows in a table format.
Current Plan:
Income for two more years while working.
Living expenses and taxes owed.
Net flows indicate how much they need to withdraw from their portfolio each year.
Observations:
Zeros in Net Flows: Indicate when income drops off upon retirement.
RMDs at Age 75: They have large RMDs, requiring them to withdraw over $70,000 they don't need, leading to unnecessary taxes.
Proposed Plan with Roth Conversions:
Higher portfolio withdrawals initially (to pay taxes on conversions).
At Age 75, surplus is now zero, avoiding unnecessary RMDs.
Increasing the Probability of Retirement Success
The best part of the Roth conversion analysis is that it actually increases their probability of success in their retirement plan.
Introducing the distribution proposal (Roth conversions up to the 22% tax bracket and optimized withdrawal sequence) increases the odds of their retirement plan working out long-term.
Less Chance of Cutting Spending: Reduces the likelihood they'll have to reduce spending at any point in retirement.
Real-Life Impact: More Money to Spend
Ultimately, this translates to them probably being able to spend more money.
They could potentially take an extra vacation each year without hurting their plan.
For example, spending an extra $500 a month in retirement might bring them back to where they were pre-Roth conversions in terms of plan success.
Implementing these changes can give them more money to spend, pay less taxes, and keep more money in their pocket.
Is a Roth Conversion Right for You?
In Tom and Camille's case, it makes sense for them to do Roth conversions up to the 22% tax bracket over the next decade or so.
However, this does not apply to everyone's situation.
Individual Factors: Your tax bracket, income needs, RMDs, and other personal factors play a significant role.
Potential Downsides: In some cases, Roth conversions can result in less money over your lifetime or more taxes owed.
Conclusion
Don't take this as specific advice for your situation, but more of an insight on how to help determine this for yourself.
Consult a Professional: It's crucial to analyze your individual circumstances.
Plan Ahead: Understanding when and how much to convert can make a significant difference in your retirement planning.
If you're wanting help determining whether or not Roth conversions make sense in your own retirement plan, schedule a free consultation with us, and we'd be happy to talk with you.
Thanks for reading, and we look forward to helping you achieve a confident and clear retirement.
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About the author
Jake Skelhorn
Jake is a CFP Professional with a focus on planning for both traditional and early retirement. He’s a Florida native, growing up in Fort Lauderdale and now residing in Jacksonville with his husband Chris and their 120-lb “puppy” Barli. Jake enjoys cooking (favorite cuisine to make is Thai), traveling, and spending time with friends and family as much as possible.
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